Bad news may be just what the market needs to shake free of its recent slump. Gordon Fowler Jr. is CIO of Glenmede Trust Company, an independent wealth advisory based in Philadelphia.

Summary We are now at the stage in the economic cycle where a little bad news would be good. Poor economic growth would signal that inflationary pressures could abate. Lower inflation means the Fed can let up on raising rates. Stock markets tend to do quite well when the economy and the Federal Reserve take a breather. Last week's economic data provided some hope that the economy is slowing down. We need, however, some more evidence of a slowdown before the economy and the markets are able to rise at a sustained rate again.

Review and outlook

The market rallied last week as economic growth data came in looking worse than expected. The market is hoping that the economic statistics due out this week turn out to be equally poor. Why is the equity market in such a masochistic mood? Because it is hoping that slower growth will lessen inflationary pressures and allow the Fed to stopraising rates for a bit. Slower growth may be an indicator of lower inflation down the road. It is not, however, a guarantee. While it is possible to be cheered by the fact that weaker growth could lead to lower inflation, the market will probably remain in a trading range until there is clear evidence that inflation has peaked.

For the week the S&P 500 rose by 3.1%, bringing its year-to-date return to 3.5%. Small-capitalization stocks rose by a bit more. The Russell 2000 index of small-cap stocks was up 4.2%. In contrast to earlier this year when the small-cap market leapt to great heights as large caps inched up, the latest rise in small caps has been much more tentative. International equities also posted a good gain, rising by 4.4%. In contrast to the past month where a weaker U.S. dollar contributed to currency gains, the rise in the markets could be attributed predominantly to a rise in local-market returns. Year to date, the international market, as measured by EAFE, is up 11.3%.

Value of the "mini cycle"

We are now in the stage of the economic cycle where we would like some bad news on the economy and incur what is known in the industry as a mid-cycle slowdown. Since the beginning of the 1980s, economic cycles have gotten longer. Prior to that point, the economy would go from boom to bust in four to five year increments.

We suspect that part of the reason for this shift is the fact that services are a more important part of the economy than before. Services are less prone to wild swings in activity than manufacturing. Another reason for the fact that cycles last longer during more recent decades is that as the economy has gotten bigger, it has become more subject to "mini cycles."

These mini-cycles generally constitute significant economic slowdowns in a particular part of the country or a particular industry. If you are in the midst of one these tempests, it is anything but fun. They do, however, tend to relieve inflationary pressures that have built up across the national economy. They also allow the Federal Reserve to stop increasing interest rates, sometimes even cut them.

Such cycles also tend to be good for the equity markets. During the 1980s, we called this phenomenon "the rolling recession." While the economy did just fine on a national level, recessions raged in various parts of the country and economy.

First, the rust bowl was hit thanks to fierce competition from the Japanese and an overvalued dollar. Next, the oil patch was hurt as sinking energy prices took down the economies of the energy-producing states. During the first part of the 1990s, Southern California and other parts of the country suffered from the "peace dividend," as reduced defense spending led to lost jobs and industries. Throughout this period, Wall Street and the economies dependent on Wall Street went through good times and bad. Cycles in trading, mergers and acquisitions, emerging market debt and junk bond financing all had an impact on the greater New York City economy.

All of these mini cycles slowed down the economy enough to keep inflation under control and allowed overall economic growth to stay on track.

The benefits of a housing bust

So, is the economy in the midst of a mid-cycle slowdown? The answer, increasingly, seems to be yes.

The residential housing market appears to be the culprit this time. Housing prices, after rising to obscene levels, are coming down (or at least softening), as inventories of unsold homes build and sales slip. Will this take us into a recession? Probably not. Home building has been a major source of new jobs. In addition, when a home transaction occurs, generally new homeowners temporarily boost their spending funded by debt. But spending on new homes is only one part of the economy. For many people, the fact that home prices go up or down has very little impact on their spending plans.

Let's take a look at the housing slowdown from the other perspective. Is it enough to slow the economy and put a lid on inflation? That is the $100 billion question. So far, the inflation numbers have not turned down and they won't for a while longer. The economy probably needs to weaken a little more. Over the next week or so, we will get some more critical economic data including the employment report.

With any luck it will be bad. --FWR

Review and outlook is intended to be an unconstrained review of issues, topics and considerations of possible interest to Glenmede's clients and is not intended to be applicable to any one particular client. Actual investment decisions for particular clients are made in light of applicable considerations and may be different from the views expressed here. Likewise, actual portfolio performance may differ from the results discussed.

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